Bloomberg News

Long Bonds Spurned as Buyers Seek Taper Shelter: Credit Markets

November 27, 2013

Bond buyers are demanding the most in at least a decade to own long-dated bonds relative to debt with short maturities as they seek to protect themselves from losses when the Federal Reserve starts scaling back stimulus.

Debt due in 15 years or longer yielded 4.34 percentage points more than those maturing in one to three years as of Nov. 20, almost double the average during the past decade, according to Bank of America Merrill Lynch index data stretching back to 2003. While the longer-dated bonds are losing 6.9 percent in what would be the worst annual decline since at least 1974, the shorter-term securities are gaining 1.8 percent.

Investors are retreating after five years of easy-money policies prompted them to pile into longer-term debt at the fastest pace ever as an alternative to short-term interest rates that the Fed has held near zero. After Verizon Communications Inc. to Apple Inc. led a 66 percent surge in outstanding debt due in 15 or more years since 2008, the notes have lost about $60 billion of value this year, the index data show.

“The short end certainly represents a safe haven,” said Michael Barnes, co-founder of Tricadia Capital Management LLC, the $3.5 billion hedge-fund firm that focuses on credit. “This is a manifestation of the market accepting that the Fed has been clear about their intent to separate tapering from tempering.”

Forecasting Losses

Even with the gap between yields on short- and long-term debt at the widest on record, longer-duration bonds may not represent a buying opportunity just yet, with Royal Bank of Scotland Group Plc strategists recommending investors stay in notes that mature sooner.

After returning an annual average of 11.7 percent in the four years after 2008, the Bank of America Merrill Lynch U.S. Corporate index is losing 1.4 percent this year as the Fed debates curtailing its $85 billion of monthly mortgage-debt and Treasury purchases. Strategists from UBS AG to Citigroup Inc. are predicting losses will deepen next year as the central bank weans the world’s biggest economy from stimulus.

“There’s clearly appetite from a subset of institutional investors to migrate from longer-duration to shorter-duration assets,” said Peter Warren, who helps manage CQS U.K. LLP’s $1.2 billion Diversified Fund. “Some institutional investors we are talking to feel that the balance of risk in interest rates may be quite asymmetric against them in the long-term.”

Taper Talk

Minutes of the Federal Open Market Committee meeting Oct. 29-30 released Nov. 20 showed that policy makers expect to reduce the central bank’s bond purchases “in coming months” as the economy improves.

The stimulus helped push yields on the longest-term corporate notes to an all-time low of 4.36 percent on Nov. 8, 2012, 1.93 percentage points less than the average during the previous decade, Bank of America Merrill Lynch index data show.

“A lot of people have moved out of long credit,” William Larkin, a money manager who oversees $520 million in assets at Cabot Money Management in Salem, Massachusetts, said in a telephone interview. “It’s the most economy sensitive and interest-rate sensitive.”

Yields on corporate bonds maturing in more than 15 years have risen to 5.34 percent, compared with an average 1.08 percent on company debentures due in one to three years, Bank of America Merrill Lynch index data show. That’s within a basis point of the record low reached in April. The gap between the two yields has averaged 2.46 percentage points during the past 10 years.

‘Stacked’ Deck

“You have the deck a little bit stacked against you” as a bond investor, said Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $415 billion. “What makes it hard is the bond market knows the Fed is going to taper, whether that comes in December or March.”

While the Fed may curtail stimulus in March, it will likely keep its target interest rate at 0.25 percent through 2015, according to the median of 73 economists surveyed by Bloomberg this month. The central bank has held the target at a range of 0.25 percent and zero since December 2008.

Longer-dated corporate bonds are declining after gaining 75 percent the previous four years. This year’s 6.9 percent drop would equal a $59.7 billion loss in market value for the $861.5 billion of notes outstanding at the end of last year on the Bank of America Merrill Lynch 15+ Year U.S. Corporate Index.

Apple Bonds

The $3 billion of 3.85 percent, 30-year bonds that Apple sold April 30 in what at the time was the biggest corporate deal ever have since dropped 15.6 cents to 83.8 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Apple, the largest U.S. maker of smartphones, sold $17 billion of debt in a six-part offering. Verizon subsequently topped the record, raising $49 billion in an eight-part offering on Sept. 11, Bloomberg data show.

Walt Disney Co.’s $500 million of 3.7 percent, 30-year debentures have fallen 13.8 cents since they were issued a year ago to 85.5 cents on the dollar, Trace data show.

Buyers are demonstrating a preference for debt that’s less vulnerable to rising benchmark borrowing costs as yields on 10-year Treasuries (USGG10YR) rise to 2.7 percent from 1.76 percent at the end of last year.

Shortening Duration

A measure of investment-grade bonds’ sensitivity to rising rates known as effective duration has fallen to 6.51 from a record 6.95 reached on May 2, Bank of America Merrill Lynch index data show. The gauge has averaged 5.96 since 1996.

“Credit investors have shortened the duration to reduce interest-rate risk in their portfolios,” Edward Marrinan, a macro credit strategist at RBS’s securities unit in Stamford, Connecticut, said in a telephone interview. “Interest rates are likely to rise when the Fed embarks on its tapering plan.”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. declined, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 0.13 basis point to a mid-price of 68.3 basis points as of 10:43 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, rose 0.13 basis point to 8.63 basis points. The gauge typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Bonds of Morgan Stanley (MS:US) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.8 percent of the volume of dealer trades of $1 million or more, Trace data show.

To contact the reporters on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net; Callie Bost in New York at cbost2@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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